Chapter 2

Working Capital Management:

Theoretical and Empirical Review

10
The corporate financial management literature conventionally focused on the study of
long term financial resources where a number of studies have analyzed the topics
related to capital structure, investments, dividends and firm valuation. However, the
short term investments of a firm with maturity less than a year in the form of current
assets also represent a major share of total assets on the Balance sheet of the
manufacturing firms. The management of these short terms assets falls in the area of
Working Capital Management (WCM).

WCM is very imperative because it affects the firm’s risk, profitability and value
(Smith, 1980). Investment in working capital involves a balance/tradeoff between risk
and profitability because investment decision which leads to increase in profitability
will be inclined to increase risk and vice versa. Efficiency in working capital
management is very important for the manufacturing firms where as previously
discussed that more than half of the assets are current assets and in wholesale and
retail business this proportion even exceeds seventy percent of total assets. Efficiency
in managing working capital also increases cash flow to the firms which in turn
increase the growth opportunities for the firms and return to the shareholders
(Ganesan, 2007). The significance of working capital management is not new in the
finance literature. Largay and Stichney (1980) reported in their study that W.T. Grant,
a nationwide chain of department stores was bankrupt because of deficit in cash flows
from operations in eight of the last ten years of its corporate life. Working capital
management is a continuous function which is linked to the survival of firms. Firms
where working capital management is not given due consideration cannot survive for
a longer period (Dong and Su, 2010).

As described earlier that one of the major functions of manufacturing firms is the
production of goods (Kavita, 2009). This function in most firms depends largely on
the Working Capital Management. Management of fixed assets falls within the realm
of capital budgeting while the management of Working Capital is a continuing
function which involves control and flow of financial resources circulating in the firm
in one form or the other. Regarding individual items of working capital, Weston and
Copeland (1992) explained that, if the forecast of a firm is perfect than it would be

11
holding optimal level of cash required for making payments, adequate inventories4 for
meeting the production and sale requirements and the amount of accounts receivable
as per the optimal credit policy. An optimal level of holdings of such individual
current assets will lead to profit maximization for the firm. However, any of the
investment above the optimum level may increase the current assets of the firm
without increasing proportionately the profits of the firm. Resultantly the rate of
return on investment declines. On the other side Weston & Copeland (1992) also
explained that if the investment in current assets falls from a certain level, it may lead
to an inability of paying bills on time and may also result in inventory shortage
leading to halting of production activities. It may also lead to loss of sales due to
restrictive credit policy by the firm.

In developed countries like United States, Canada, England and Australia, it has long
been recognized that the efficient working capital management is critical for
prosperity and survival of firms’ specially small and medium enterprises
(Grablowsky, 1984; McMahon and Holmes, 1991). These researchers indicated that
“poor” or “careless” financial management is a major reason of failure for small
businesses (Berryman, 1983).

Pass and Pike (1984) emphasized that short term finance area particularly working
capital management was given very less attention in contrast to long term investment.
Working capital management played a very vital and important role in the growth of
firm and in enhancement of profitability. Pass & Pike (1987) in continuation of their
work (Pass and Pike, 1984) have discussed that deficiency in the planning and control
of working capital management is one of the main causes of business failure and it is
a neglected subject which has been all too little investigated or written about. Pass and
Pike (1987) also explained that the two main objectives need to be satisfied by
working capital management are liquidity and profitability but not at the cost of one
and another. There should be a trade-off / balance between these two objectives.

Similarly, Working capital was described as the life blood of every business by
Flanagan (2005), who also emphasized that the primary task of every manager’s is to

4
Manufacturing sector of Pakistan has on average 40% inventory value in current assets based on
manufacturing firms data extracted from their annual reports.

12
keep working capital flowing and use the cash flows to generate profits. Furthermore,
each component of working capital has two dimensions which are time and money
and when it comes to managing working capital, time is money. Moreover, he
stressed that the impact of working capital be fully assessed when planning the
development of a business and making forecast of cash flows. According to Filbeck
and Krueger (2005), the role of efficient working capital management was indubitable
and the viability of business relied on effectively managing inventory, accounts
receivable and accounts payable. Furthermore, firms were able to reduce financing
costs and increased the funds available for expansion by minimizing the amount of
funds tied up in current assets. Filbeck and Krueger took industry membership into
consideration when estimating stock price reaction against working capital
management performance. Furthermore, they highlighted that there existed significant
differences between industries in working capital measures across time. In addition
working capital measures, themselves, change significantly within industries across
time.

The above studies indicate that the working capital management has become a very
important part of a firm’s financial management because its management not only
affects the survival of firm but the profitability of the firm is also dependant on how
effectively and efficiently working capital is utilized in the firm’s operations.
Therefore, it is vitally important to see that how a trade-off can be maintained in two
conflicting goals of Profitability and Liquidity. In this regard, a theoretical
background is presented between profitability and liquidity.

2.1. Profitability versus Liquidity

Finance emerged as discipline around 60 years ago from the disciplines of accounting
and economics. For number of years maintaining liquidity was one of the prime goals
of the firms and financial managers and they kept focusing their attention on
maintaining higher liquidity to be safe against risk of default. This focus was mainly
due to the reason that, at that time the financial viability of firms was associated to
their liquidity.

13
Ultimately, it was felt that maintaining high liquidity affects the profitability of firm
in an adverse manner. It was mainly due to the reason that most of the assets of the
firm were retained in the current form i.e. cash, marketable securities, receivables and
inventory. The profitability and liquidity, both are important goals for any firm and to
forego one goal at the cost of other can create serious problems for the firm.
Profitability is a long term goal for any firm because it is required for the survival of
the firm and firm will not continue to exist without profits. On the other side liquidity
is relatively shorter term goal which needs to be addressed to protect the firm from
bankruptcy (Seereiter, 1981).

Different authors addressed this issue of maintaining a trade off between these two
conflicting goals of profitability and liquidity but only gave a general approach to
solve the problem like Smith (1980) proposed forecasting of liquidity and profitability
in a analogous way to maintain a trade off. On the other side Walker (1964) stated
that increased investment in working capital is associated with decreased risk of
inadequate liquidity, risk of lesser inventory for sales and risk of not granting credit
for sales and production. Similarly if the firm decreased investment in working
capital, it will increase the above mentioned risks. However, increased risk also
increases profitability of the firm as the decreased investment in working capital can
be used for some productive use. Weston and Brigham (1975) also discussed this
trade off issue and suggested that investment in working capital should be made till
that time, marginal return are more than cost of invested capital and working capital
financing should be used instead of long term financing as long as their use does not
increase firm’s cost of capital. The study conducted by Walker (1964) mentioned
above also took the similar approach where he encouraged the use of more working
capital assets but emphasized on the risk involved as the major determinant of degree
of working capital investment.

Another study by Bean and Griffith, (1966) also discussed this issue of trade off with
specific emphasis on the risk involved. Two functions were hypothesized by them,
where, one related the return on the investment to the amount of working capital
investment, while the other related to the risk of insolvency (cash) to the investment
level in working capital. They highlighted in their study, that the best or optimal level
of investment in working capital is one which maximized the difference in return on

14
working capital investment curve and risk of having insufficient working capital
curve. Bean and Griffith also presented a numerical technique to approximate the
required level of investment in working capital by calculating risk and return for
different levels of working capital. Similarly Horne (1975) also proposed a method
for making risk and return relationship by incorporating the maturity structure of the
firm’s debt.

Working capital management was interrelated with the capital structure decision by
Bierman et. at., (1975). They assumed that the earnings of the firm were a function of
the level of working capital a firm maintained. They used working capital as a buffer
and also to affect sales by changing inventory level and credit policies.

In another study, Working Capital Cycle was discussed by Lambrix and Singhui
(1979), who stated that the Working Capital Cycle was influenced by physical flow of
product, the paperwork flow of payables and receivables and cash flows. They
explained that increase in the length of working capital cycle is associated with
increase in working capital investment. Further length of working capital cycle can be
decreased by reducing time between purchase of material and production and sale,
eliminating deficiencies in paperwork flow, improving terms of purchasing goods and
effectively managing the receipts and payments.

Miller (1979) defined working capital in its traditional way. According to him current
assets are equated by current liabilities and working capital because these current
assets are supported by current liabilities and working capital. It is similar to the
accounting equation where total assets are supported by total liabilities and equity.
Further he said that working capital is the permanent capital of the firm which is
invested in the current assets. He discussed the sources and uses working capital and
supported that the liquidity of a company should be evaluated on the basis of
difference between actual working capital of the company and its base or necessary
working capital level. According to him the base or necessary level of working capital
is that level which is required for the operations.

Almost all of the studies discussed above explains the liquidity, risk and profitability
relationship and tinted that there should be trade-off or balance in these two. The

15
profitability and risk varies inversely with liquidity while profitability and risk go
hand by hand. Lot of research in international context has been on the individual
components of working capital. We have included those researches in our further
review which include all major components of the working capital management and
specifically on the relationship between working capital management and corporate
performance. All individual components of working capital including cash,
marketable securities, account receivables and inventory management plays a vital
role in the success of any firm and the level of these components has its impact on the
performance of the firm. Shin and Soenen, (1998) highlighted that efficient working
capital management is very important to create value for the shareholders. Smith
et.al., (1997) emphasized that profitability and liquidity comprised the salient goals of
working capital management. Therefore, in the next portion of this chapter, we
present the studies specifically on the relationship between working capital
management and the corporate performance.

2.2 Working Capital Management and Firm Performance

Working capital management refers to all the actions and decisions of the
management which affects the size and effectiveness of working capital. Working
capital management requires special attention in present days when cost of capital is
rising and funds are scarce. It has been generally established that the performance /
profitability of a firm largely depends upon the manner of its working capital
management. If a firm is inefficient in managing working capital, it will not only
reduce profitability but may also lead to financial crisis. Both inadequate and
excessive working capital is detrimental for a business concern. The excessive
working capital can result in idle funds which could be used for earning profit while
the inadequate working capital will interrupt the operations and will also impairs
profitability (Chowdhary and Amin, 2007).

Most of the empirical studies regarding working capital management and profitability
relationship support the traditional belief that reducing current assets proportion in
total assets in order to reduce working capital investment, would positively affect the
profitability of firm (aggressive policy). Deloof (2003), who analyzed a sample of
Belgian firms, and Wang (2002) who analyzed a sample of Japanese and Taiwanese

16
firms, both emphasized that the way the working capital is managed has a significant
impact on the profitability of firms and increase their profitability by reducing number
of days, accounts receivable and reducing inventories. A shorter Cash Conversion
Cycle and Net Trade Cycle are related to better performance of firms. Further,
efficient working capital management is very important to create the value for
shareholders. Shin and Soenen (1998) analyzed a sample of US firms and also has
similar type of findings but have used Net Trading Cycle as comprehensive measure
of working capital management and found significant negative relationship between
NTC and profitability. However, this relationship was not found to be very significant
when the analysis was for specific industry (Soenen, 1993). Industry wise analysis
was also performed by Jose et al (1996), who measured the ongoing liquidity by Cash
Conversion Cycle. Controlling industry and size differences they have concluded that
more aggressive liquidity management is associated with higher profitability for
several industries.

However, divergent to traditional belief, more investment in working capital

(conservative policy) might also increase profitability. When high inventory is
maintained, it reduces the cost of interruptions in the production process, decrease in
supply cost, protection against price fluctuation and loss of business due to scarcity of
products (Blinder and Maccini, 1991). Czyzewski and Hicks (1992) also concluded
that firms with the highest return on assets hold higher cash balances but they did not
consider liquidity management beyond static cash and assets ratio.

Researchers have focused to evaluate the working capital management and

profitability relationship which include Gill et al., 2010; Sen and Oruc, 2009; Uyar,
2009; Falope and Ajilore, 2009; Mathuva, 2009; Samiloglu and Demirgunes, 2008;
Vishnani and Shah, 2007; Garcia-Teruel and Martinez-Solano, 2007; Lazaridis &
Tryfonidis, 2006; Padachi, 2006; Deloof 2003; Ghosh and Maji, 2003; Wang 2002;
Shin and Soenen, 1998; Smith et al., 1997 and Jose, Lancaster and Stevens, 1996
among others.

One of the recent studies on the relationship between working capital management
and profitability was conducted by Gill et. al., (2010) for American firms listed on
New York stock exchange. They used the data for a sample of 88 American firms for

17
a period of three years from 2005 to 2007. They found statistically significant
relationship between working capital management and firm’s profitability.
Furthermore, it was observed that there was a negative relationship between average
days of accounts receivable and firm profitability while positive relationship between
cash conversion cycle and profitability. As per their finding, the managers can
enhance profitability of their respective firms by properly handling cash conversion
cycle and also by keeping the accounts receivable at an optimal level. Moreover,
negative relationship between firm’s accounts receivable and profitability suggested
that less profitable firms pursue a decrease in their accounts receivables to reduce the
cash gap in CCC.

The impact of working capital management on firm profitability was also examined
by Falope and Ajilore, (2009) using data for fifty Nigerian non financial listed firms
on Nigerian Stock Exchange during period 1996 to 2005. They used combined time
series and cross sectional observations in a pooled regression to estimate the
relationship between working capital measures and firm’s profitability. They found
significant negative relationship between profitability and working capital measures
such as average collection period, inventory turnover in days, average payment period
and cash conversion cycle. They also compared this impact between large and small
firms but did not find significant variations among these firms.

The relationship between efficiency in working capital management and profitability

was also analyzed in another study by Sen and Oruc, (2009). Using quarterly data for
49 production listed firms during 1993 to 2007 on Istanbul Stock Exchange, they
explained the relationship between different indicators of working capital
management efficiency and return by two models. The results of their study indicated
a significant negative relationship between return on total assets and different working
capital measures such as, account receivable period, inventory period, cash
conversion cycle, net working capital level and current ratio. In this study, although
the sample was small but sector wise results were also compared where, the results
were similar to the one for the overall sample firms.

The relationship of one of the comprehensive measure of working capital

management called as Cash Conversion Cycle with firm size and profitability was

18
examined by Uyar, (2009) for firms listed at Istanbul Stock Exchange. The results
showed retail/wholesale industry has shorter CCC than manufacturing industries
because retail/wholesale industry do not manufacture goods and sell them on cash
basis or for very short credit period. Furthermore, they found significant negative
correlation between CCC and profitability as well as between CCC and firm size.
Another study on the impact analysis of working capital management on profitability
of firms with reference to Turkey was presented by Samiloglu and Demirgunes
(2008). The quarterly data was collected for a sample of manufacturing firms listed at
Istanbul Stock Exchange for the period 1998 to 2007. The results suggested that
receivable and inventory period with liquidity has a negative impact on the
profitability of the firm while growth was positively associated with profitability.
However CCC, size and financial assets did not have significant effect on the
profitability of the firms.

With reference to small and medium sized Spanish firms, the impact of working
capital management on the profitability was empirically tested by Gracia-Teruel and
Martinez-Solano (2007). They used panel data methodology and collected the data for
8872 small and medium sized firms covering period 1996 to 2002. The robust test
was also used for any possible presence of endogeneity problem. The results
suggested that working capital management was very important in case of small and
medium sized firms and managers can create value for the shareholders by reducing
the inventories level and receivable outstanding days. Further short Cash Conversion
Cycle is also associated with improvement in profitability. However their results did
not confirm the impact of accounts payable days on profitability because this relation
loosed its significance when controlled for endogeneity problem.

The role of working capital management policies on firm performance and the
importance of a tradeoff between liquidity and profitability were investigated by
Vishnani and Shah (2007). They provided two basic reasons behind the tradeoff
between profitability and liquidity. On the one hand if a firm wanted to take higher
risk for higher profits, than it reduced the level of its working capital. On other hand if
firm wanted to improve liquidity, it increased the amount of working capital which
puts a negative impact on the profitability of firm. The relationship between working
capital management and profitability was specifically assessed in this research for the

19
Indian consumer electronic industry for period 1994-95 to 2004-05. The results of this
study as a whole did not find established relationship between liquidity and
profitability but these results vary in companies of industry but for most of the
companies found a positive relationship between liquidity and profitability. They also
found negative association between working capital management policies and
practices with the performance measured in terms of profit.

The impact of overall working capital policies on the profitability of Pharmaceutical

firms listed at Dhaka Stock Exchange was investigated by Chowdhary and Amin,
(2007). The primary and secondary data was used for the period 2000 to 2004 to
analyze the working capital management policies. The results indicated that for the
overall performance of the Pharmaceutical industry, working capital management
played a vital role and there existed a positive relationship between current assets
management and performance of firms. On the other side the questionnaire data used
for the study highlighted that firms in this industry have been efficient in managing
their cash, accounts receivables and accounts payable. Further this industry
maintained large volume of inventories but maintaining large inventories didn’t
reflect inefficient management for this industry.

The relationship of corporate profitability and working capital management was also
investigated by Lazaridis & Tryfonidis, (2006) for 131 firms listed in Athens Stock
Exchange during period 2001 to 2004. They reported that there was statistical
significant negative relationship between profitability measured through gross
operating profit and the Cash Conversion Cycle. Furthermore, managers can create
profit by properly handling the individual components of working capital which
include accounts receivable, inventory and accounts payable to an optimal level.

The trend in working capital management and its impact on firm’s performance was
examined by Padachi, (2006). He explained that a properly implemented working
capital management was expected to contribute in creating value for the firm. The
relationship between working capital management and profitability is investigated for
58 small Mauritian manufacturing firms for a period 1998 to 2003. Results indicated
that high investment in inventories and receivables is associated with low profitability

20
and also showed an increasing trend in the short term component of working capital
financing.

The liquidity management through working capital approach has long been the
prominent technique. Many analysts advocate the use of current and quick ratios
instead of using working capital as a measure of liquidity. The advantage of using
these ratios was that these help in making temporal or cross sectional comparisons
possible. However, the ultimate measure of the efficiency of liquidity planning and
control is the effect it had on profits and shareholders' value. One of the important
studies on the liquidity and profitability trade off was conducted by Eljelly (2004).
According to him current assets and liabilities must be properly planned and
controlled in such a way that the risk of inability in meeting short term obligations
should be eliminated and avoid excessive investment in current assets under efficient
liquidity management. The relationship between liquidity and profitability was
examined using a sample of 29 Saudi joint stock companies. This relationship was
analyzed by cash gap (CCC) and Current Ratio using correlation and regression
analysis. The results of the study found significant negative association between
liquidity and profitability of firm. Furthermore, this relationship was more apparent in
firms with high Current Ratios and longer CCC at the industry level, however, the
study also found that the CCC was of greater importance than current ratio as a
liquidity measure which affects firm profitability. Moreover, the size of the firm was
found to have significant effect on profitability at the industry level.

Another important contribution with reference to working capital management was by

Deloof (2003), who emphasized that most firms had a large amount of cash invested
in working capital. It can therefore, be expected that the way working capital was
managed, had a significant impact on the profitability of firms. He investigated the
relationship between working capital management and corporate profitability for a
balanced panel set of 1,009 Belgian firms over the 1991–1996 periods. According to
him, a longer Cash Conversion Cycle lead to larger investment in working capital and
longer Cash Conversion Cycle might increase profitability because it leads to higher
sales. However, corporate profitability might also decrease with the Cash Conversion
Cycle, if the costs of higher investment in working capital rose faster than the benefits
of holding more inventories and/or granting more trade credit to customers. Number

21
of days’ accounts receivable, accounts payable and inventories were used as trade
credit policy and inventory policy while the CCC was used as a comprehensive
measure of working capital management. He found a significant negative relation
between gross operating income and the number of days’ accounts receivable,
inventories and accounts payable by Belgian firms. On the basis of these results he
suggested that managers could create value for their shareholders by reducing the
number of days’ accounts receivable and inventories to a reasonable minimum. The
negative relation between accounts payable and profitability was consistent with the
view that less profitable firms wait longer to pay their bills.

Working capital management efficiency in Indian Cement Industry for the period
1992-93 to 2001-02 was examined by Ghosh and Maji (2003). For measuring the
efficiency of working capital management, the performance, utilization, and overall
efficiency indices were calculated instead of using some common working capital
management ratios. Setting industry norms as target-efficiency levels of the individual
firms, they also tested the speed of achieving that target level of efficiency by an
individual firm during the period of study. Findings of the study indicated that the
Indian Cement Industry as a whole did not perform remarkably well during this
period.

Another important study on the relationship between liquidity management and

operating performance was conducted by Wang (2002). His study also examined the
relationship between liquidity management and corporate value for firms in Taiwan
and Japan. He found negative relationship between Cash Conversion Cycle, return on
assets and return on equity which was also sensitive to industry factors. The results of
the study indicated that although there were differences in financial system and
structural characteristics of both countries, still aggressive liquidity management
increased the performance which also leads to increase in the corporate value for
Japanese and Taiwanese firms.

The implication of efficient working capital management for value creation of

shareholders was highlighted by Shin and Soenen (1998). It actually resulted from
time lag between expense on raw material purchase and collection of cash against sale
of finished goods. The way working capital is managed has a significant impact on

22
the profitability and liquidity. They empirically investigated, whether short Net
Trading Cycle (NTC) is beneficial for the company’s profitability. The relationship
between the length of Net Trade Cycle, firm’s profitability and risk adjusted stock
return was examined using correlation and regression analysis. The analysis was
carried out using a sample of 58,985 firm years during period 1975-1994. The results
of study found a strong negative relationship between firm’s net-trade cycle and
profitability. Furthermore, shorter NTCs are associated with higher risk adjusted stock
returns.

The comparison between association of traditional working capital ratios and

alternative working capital ratios to the return on investment in order to found the
improvement in the later was carried out by Smith et. al., (1997) specifically in
industrial firms listed on the Johannesburg Stock Exchange (JSE). They emphasized
that those who promote working capital theory share that profitability and liquidity
comprised the salient goals of working capital management. The problem arises
because the maximization of the firm's returns can seriously threaten the liquidity, and
the pursuit of liquidity had a tendency to dilute returns. Analysis was based on data
set of 135 firms, representing all industrial firms listed on the JSE for the years from
1984 to 1993. The results of the stepwise regression corroborated that total current
liabilities divided by funds flow accounted for most of the variability in Return on
Investment (ROI). The results also showed that a traditional working capital leverage
ratio, current liabilities divided by funds flow, displayed the greatest associations with
return on investment. Well-known liquidity concepts such as the current and quick
ratios have insignificant associations whilst only one of the newer working capital
concepts, the comprehensive liquidity index, indicated significant associations with
return on investment.

The relationship between ongoing liquidity measure in terms of Cash Conversion

Cycle and corporate returns was examined by Jose et al (1996). They performed an
industry wise analysis and measured the ongoing liquidity by Cash Conversion Cycle
for 2,718 firms for twenty years time period from 1974 to 1993. Controlling industry
and size differences they have concluded that more aggressive liquidity management
is associated with higher profitability for several industries. The negative relationship
between CCC and profitability was found to be significant when size differences were

23
controlled. They also found that aggressive policies of working capital management
tend to enhance performance and the industries where aggressive policies were
adopted, they were more profitable. The benefits appear in terms of both assets
management return measured by return on investment and leveraged return measured
by return on equity.

Another study on the relationship between Cash Conversion Cycle and corporate
profitability was performed by Soenen (1993) at the industry level. Soenen employed
return on total assets as an index of financial profitability. Although return on equity
might be of greater interest to investors, return on total assets was not influenced by
the financial leverage of the firm. The Net Trade Cycle and the return on total assets
were calculated for all firms in each industry for every single year from 1970 to 1989
to find out the inverse relationship between Net Trade Cycle and return on total
assets. The results showed that although there was some influence of the Net Trade
Cycle on corporate profitability, the trade cycle did not influence profitability very
much. The "right" associations of a short Net Trade Cycle with high profitability and
the combination of a long Net Trade Cycle with low profitability was found in 18 of
the 20 industries. However, using the Chi-square test, the negative relationship
between the Net Trade Cycle and corporate profitability was statistically significant
for eight industries. The results demonstrated that shorter Net Trade Cycles were most
commonly associated with higher profitability while the reverse was also true.
Analysis at the specific industry level indicated that the inverse association between
the Net Trade Cycle and the firm's profitability was very different, depending on the
type of industry. The results showed that, in most firms in these industries, managing
the corporate cash cycle efficiently has a direct impact on corporate profitability.

All of the above studies have highlighted the relationship between working capital
management and corporate performance for number of countries which explains that
efficiency in working capital management leads to better performance by the firms. If
firms can manage to reduce its cash conversion cycle, average collection period and
inventory turnover in days, it leads to increase the profitability of the firm. There are
also few studies on working capital management with reference to Pakistan. Few of
them are on the relationship between working capital management and corporate

24
performance while rests of the studies are on other aspects of working capital
management

2.3: Working Capital Management in Pakistan

Efficient utilization of working capital has a direct bearing on the corporate

profitability. It also augments the productivity of investment in fixed assets of a firm.
If adequate working capital is not available on time for the firms, their survival can be
at stake. Therefore, it is very essential to maintain an adequate supply of working
capital for healthy growth of an enterprise (Jain, 2004). Lack of empirical evidence on
the working capital management and its impact on the firm performance in case of
manufacturing sector of Pakistan is main motivating force to study the subject in more
detail. There are few studies with reference to working capital management in
Pakistan like Afza and Nazir (2008) investigated the factors determining the working
capital requirements for a sample of 204 firms in sixteen manufacturing sub sectors
during 1998-2006. The results of their study indicate that working capital
management plays significant role in firm’s profit, risk and it value creation. Further,
it also requires day to day supervision and maintaining proper level of its components
like cash, receivable, payables and inventory. Another study by Afza and Nazir
(2007) investigated the relationship between aggressive and conservative working
capital policies for a sample of 205 firms in 17 sectors listed on Karachi Stock
Exchange during 1998-2005. They found a negative relationship between the
profitability measures of firms and degree of aggressiveness of working capital
investment and financing policies.

Raheman and Nasr (2007) analyzed the relationship between working capital
management and corporate profitability for 94 firms listed on Karachi Stock
Exchange using ordinary least square method. They have used the static measure of
liquidity and ongoing operating measure of working capital management during 1999-
2004. The findings of study suggested that there exist a negative relation between
working capital management measures and profitability. Furthermore, liquidity and
leverage has a negative relation with profitability while size has positive relation with
profitability. Another study on the relationship between working capital management
and profitability is by Shah and Sana (2006) using a very small sample of 7 Oil and

25
Gas sector firms to investigate the relationship for period 2001-2005. The results
suggested that managers can generate positive return for the shareholders of Oil and
Gas firms by managing working capital. Further, working capital management
practices explain the changes in firm’s profitability.

2.4: Critical Analysis

Most of the studies discussed above are analyzing the relationship between working
capital management and profitability for the overall sample firms including firms
from different sub-sectors/ industries. Therefore, the findings of these studies are
general and cannot be implicated for all sectors/industries which have different types
of requirements, structure and industry differences. These studies include such as Gill
et al., 2010; Samiloglu and Demirgunes, 2008; Gracia-Teruel and Martinez-Solano
2007, Lazaridis and Tryfonidis, 2006; Deloof 2003; Shin and Soenen, 1998 and
Raheman and Nasr, 2007 among others

Similarly in many studies discussed above like Flope and Ajilore, 2009 (50 firms);
Sen and Oruc, 2009 (49 firms); Padachi, 2006 (58 firms) and Eljelly, 2004 (29 firms),
the sample size is less than 60 firms and even in case of Shah and Sana, 2006, the
sample is 7 firms. Hence the results of these studies cannot be generalized for those
countries and for all industries. There are number of studies where the analysis is
made for a small span of time. For example Gill et. al., (2010) the data was used only
for 2005 to 2007, in Uyar, (2009) only for 2007, Chowdhary and Amin (2007) for
year 2000 to 2004, Lazaridis and Tryfonidis, (2006) for 2001 to 2004 and Shah and
Sana for period 2001 to 2005.

In most of the studies reviewed above, the analysis is made using ordinary least
square method whereas, only few studies like Deloof, 2003; Garcia-Teruel and
Martinez-Solano, 2007 and Padachi, 2006 have used fixed effect model which takes
into account firm specific intercept and better estimate the equation.

26
2.5: Conclusion

The above studies indicate that if firms are efficient in their working capital
management, they will be more profitable. In most of the studies discussed above,
there exist a negative relationship between measures of working capital management
and corporate profitability. The measure of working capital management includes
Cash Conversion Cycle and its components. Those components are Average
Collection Period, Inventory Turnover in Days and Average Payment Period.
Generally, the cash conversion cycle is negatively associated with firm profitability
however in some studies this comprehensive measure has positive relationship with
the profitability due to increase in sales. Similarly in most of the studies receivables
and inventory turnover in days are negatively associated with profitability while
payable turnover in days is positively associated with profitability.

A detailed and comprehensive literature review indicates that working capital

management has attracted academician and practitioners in various parts of the world.
But this important subject could not get much attention in Pakistan. The above review
of different studies identifies that there are no reported studies with reference to
manufacturing sector of Pakistan where the performance of different working capital
measures and impact of working capital management on corporate performance is
investigated in detail and compared on sectoral basis for manufacturing firms listed in
Karachi stock exchange. Only few studies are available and these too are restricted to
factors determining the working capital requirements and working capital investment
and financing policies. Few other studies are based on very limited sample and time
frame so it is need of time to investigate this important manufacturing sector of
Pakistan on sectoral basis with a large set of sample firms and extended study period.

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